We started our previous letter by pointing out that despite its 20%, Indian market is not very special – other countries have rallied as well, some far-far more. The ensuing three months have made Indian equities even less special. Everything seems to be rallying. Economist ran a cover feature recently called The bull market in everything. It had a picture of a bull with Bitcoin hanging from one horn and iPhone hanging from the other. How appropriate.

We see two common reactions to this market,Reaction A: I’ll just wait. It’ll come crashing down. It always does. Or the less common, Reaction B: Can’t miss this one! This time is different. After all, Bitcoins and smartphones were not even a thing a few years ago so don’t let history get in the way of making money.

We prefer reaction C: There’s still so much misery all around. Let’s go shopping. Consider this, more than one-third of all major US stocks are in the red for the year. Many are close to their 52-week lows. Several, like Exxon and GE, are lower than they were 10 years ago. The situation is no different in India. The problem is not that it’s a bull market in everything. The problem is that what’s good is expensive and what’s cheap is garbage, for most part.

To us it still makes sense sift the garbage and evaluate each situation on its own merit. Like Tolstoy once famously said about the stock market – “All high fliers are alike but each shitty situation is shitty in its own way”.

When we rummage through the trash we ask ourselves some simple questions such as, Can this particular problem be solved?Why would anyone solve it?How long will that take to solve?Will the emergent entities make money?Will they make money for us, the minority shareholder?

Most of the times the answers say “do nothing” but sometimes interesting stuff turns up. For example, for years now we’ve been following the non-performing loan circus at the government owned banks. By most accounts the total amount of bad loans at these banks – (INR) 8.5 trillion plus, is higher than their combined net-worth of about 6 trillion. Reasonable people can disagree on the exact numbers but there’s no denying that many public sector banks are de facto insolvent. Miraculously, solvency issues have not yet led to bank runs.

The left side of the balance sheet, roughly 90 trillion, of which 10% is impaired, keeps getting worse. Yet the right side keeps financing it while patiently waiting for things to get better. Depositors, who finance close to 75 trillion, stick around because either,

a) It’s a logistical hassle finding a private bank close by, or

b) They receive their subsidy and income checks in these banks, or

c) They believe the government will make them whole in case of a failure.

Government, who directly owns more than 50% of the equity, has little incentive to do things that will lead to turmoil amongst employees and their unions. More than one-fifth of the remaining equity is owned by LIC, the government owned life insurer. Bankers don’t want to just write bad loans off since that will make them look clueless or corrupt, likely both. Besides, there is hardly enough equity to absorb the losses. The central bank is trying hard to move the process along – with constant monitoring, public shaming, forced liquidations, etc., but to little effect. Our starting hypothesis is that until we face a real liquidity crisis we’ll tread water.

In the midst of this milieu, the Modi government recently announced a 2 trillion recap plan with a two year timeline. The details of the plan are not out yet but it’s looking a little bit like the bank recaps done in Korea, Indonesia, and others in late 90s. Net-net the government will end up owning more bank equity. The money required to buy the new equity will be lent by the banks themselves. In exchange for cash-like assets (the banks have more of those than they want after demonetization) the banks will receive government backed recap bonds. Presumably the government will pay the extra interest on this bond issuance from higher tax revenue and dividends received from banks, which in turn will happen because a recap will lead to higher growth. That’s it, problem solved! Call us crazy but we are not biting, at least not before we see more evidence.

Interestingly though we might see other tangential opportunities as a result of this exercise. For instance, we are now getting close to election season with a slowing and (relatively) underperforming economy. It’ll soon be critical for Modi government to start some banner projects - projects like roads and power plants that make for good electioneering platforms. This will require some abandonment of fiscal targets, some arm twisting of banks to make them lend, and some bailouts for the currently hamstrung infrastructure developers. The recap exercise seems like a step in that direction. If we are right then Infrastructure, one of the worst performing sectors of the recent past, will throw spectacular investing opportunities. So far it’s mere speculation but a promising one with enough historical precedent. We continue looking for best ways to gather evidence, express our view in case we’re right, and limit our downside in case we’re wrong.

New investment: Bharti Infratel Another area currently going through serious pain is the Indian telecom sector. In a previously eleven player market with rock bottom ARPUs, terrible service, and mostly 2G subscribers, Mukesh Ambani, India’s wealthiest man, rammed himself in by doling out (almost) free 4G connections. It took Ambani, six years and $25bn to get his venture, Reliance Jio, going but once he did there was no looking back. From a standing start less than a year ago, Jio has now gathered more than 100M subscribers. According to Ambani, this has never been done before, anywhere in the world. We believe him. He is committed and will spend more – anything to get a substantial piece of a billion- subscriber market.

Obviously, this has caused a bedlam of sorts. We looked closely at the entire telecom value chain and asked ourselves those same questions. Most businesses appear entirely hopeless to us. However, there are some that have a bright future yet remain grossly mis-priced. One such business is Bharti Infratel.

Our simple analysis starts with the hypothesis that Indians will consume far more data in future than they do now. Aggregate data consumption, mostly thanks to Jio and its freebies, has gone up from 150m GB to 1.3bn GB within the last year. That’s about 9x+ increase in one year. There’s little reason it won’t increase another 10x over the next 5 years. Monthly cost of data in India at $1.25/GB is about the lowest in the world both on absolute and relative (to GDP per capita) basis. Yet only 27% of Indians have access to the internet.

Behaviorally, mobile data is an addiction that’s almost impossible to kick. The world uses more of it every passing day. There’s no public health outcry against the habit. Unlike other addictions, this one is encouraged by the governments. It’s available at ever lower prices. It’s rapidly eating away every attention minute we have available. This looks like a lasting trend to us. Many more Indians will consume ever larger amounts mobile data in the future.

In order to fill this need India will need better technology and more telecom infrastructure. There are as many competing versions of mobile tech/infra visions as the number of telecom analysts out there. We don’t know which “G” Indians will be using five years from now – currently about 70% are still on 2G, many of them skipping 3G altogether and moving to 4G! We don’t know how much spectrum will be required, what wavelengths will be used, or how the data will be backhauled from the towers to the data centers. But we do know that in every possible scenario we’ll either need lots of towers or more equipment on each existing tower.

The tower business at its core is a real estate plus legal business. You arrange land parcels, put up basic structure and uninterrupted power, let mobile operators install equipment, charge them rent, and write water-tight, escalating, long-term contracts. Historically, the Indian tower companies have begun operations as subsidiaries of mobile operators and later spun off into separate entities. As a consequence, tower assets are still partially or wholly owned by operators. (Bharti) Infratel is the largest such entity majority owned by Bharti Airtel, the #1 Indian mobile operator. Its towers are built on some of the most sought after real estate resulting in high tenancies-per-tower. The company generates almost a billion USD in EBITDA and $500M plus in free cash flow. It’s extremely conservatively financed with zero debt and some balance sheet cash. As a comparison, American tower companies typically operate with 5-7x Debt/EBITDA. It also has far better growth prospects then its global competitors. However, despite such operating characteristics, it sold off along with the rest of the sector after Jio’s entry. The stock was available close to 52 week lows and at about 40% discount to its global peers when we started buying it last quarter. The parent company, Bharti Airtel, is looking to sell its Infratel stake to pay off its own debts and fund future capex. The likely buyers (mostly private equity) are bound to lever the entity to appropriate levels hence increasing the returns on equity. Another interesting possibility may come about in a potential merger with Indus Towers, the other large tower operator in India. Infratel already owns 42% of Indus and eventual consolidation is looking increasingly likely. This will result in a massive combined market share, a wider moat, and far better leverage levels. None of this is currently priced into the stock. The stock is up about 30% since we bought it. We plan to hold this for a long time.

With so much happening, policy and otherwise, we remain excited about all the investing opportunities these changes will throw off. We believe that India will stay a stock picker’s market for a long time to come.

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Letters to Investors

A collection of our views, thoughts and ideas, as we communicated to our investors.